- Strangi III Gives New Guidelines for Using Family Limited Partnerships as a Valuation Discount Tool
- September 23, 2005 | Authors: R. Frederick Caspersen; Michael L. Korbholz; Jeralyn A. Seiling
- Law Firms: Farella Braun + Martel LLP - St. Helena Office ; Farella Braun + Martel LLP - San Francisco Office
For some time, family limited partnerships (FLP's) have been a vital instrument for managing and transferring family wealth. Recently, however, the IRS has been attacking their use as a discount valuation tool. In 2003, the case of Estate of Strangi v. Commissioner, T.C. Memo. 2003-145 (2003) [Strangi II], caused serious concern among estate planning professionals by casting doubt on the continuing viability of the FLP as a strategy for minimizing the taxable estate.
On July 15, the Fifth Circuit released its opinion in Strangi III, affirming the decision of the Tax Court in most respects. Estate of Strangi v. Commissioner, No. 03-60992, (5th Cir. filed Jul. 15, 2005) [Strangi III]. At first glance, this decision may seem like bad news for taxpayers. However, Strangi was an extreme case involving a fact pattern that weighed heavily against the taxpayer. The result of Strangi III, then, is to clarify how to structure an FLP in order to minimize tax consequences. We recommend that clients with family partnerships review their estate plans with us to ensure that the plans take account of these new guidelines.
The Strangi FLP and I.R.C. § 2036(a)
§ 2036(a) of the Internal Revenue Code essentially provides that transferred assets can still be included in the taxable estate if prior to death the decedent retained (1) possession or enjoyment of the assets or (2) the right to designate persons who shall possess or enjoy the assets. There is an exception to this rule if the transfer is a bona fide sale for adequate and full consideration.
In Strangi II, the tax court determined that § 2036(a) applied to an FLP held by the Strangi family, thereby increasing the estate's tax liability considerably. Many were surprised and discouraged when the normally taxpayer-friendly Fifth Circuit affirmed this ruling, holding that decedent had retained possession or enjoyment of the transferred assets within the meaning of § 2036(a)(1).
However, it is important to recognize that the facts of the Strangi case were particularly bad for the taxpayer involved. The Fifth Circuit's ruling turned on the following facts:
- Albert Strangi, virtually on his deathbed, had transferred 98% of his assets including his residence into an FLP.
- Mr. Strangi retained ownership of 99% of the FLP, and the other 1% was owned by a corporate general partner in which Mr. Strangi also had an ownership interest.
- The corporation, and by extension the FLP, were managed by Mr. Strangi's son-in-law, who was also his attorney-in-fact.
- Mr. Strangi continued to live in the house he had transferred to the FLP and, while he "owed" rent on the books, the rent was only paid by his estate two years after his death.
- Mr. Strangi had retained insufficient assets to meet his living expenses, and most of the expenses associated with his final months of life and with his funeral were paid with distributions from the FLP. He also accumulated debt which was paid by the FLP.
- The FLP never made any investments or conducted any active business after its formation.
The court's ruling was tied closely to this specific set of facts, and did not call into question the general viability of the FLP as a tool for transferring assets. Essentially, the court held that the facts indicated Mr. Strangi had not really given up possession or control of the assets, and that he expected to be able to use his assets as needed after the transfer. The real significance of Strangi III lies not in the fact that the taxpayer lost, but in the new guidance the court gave for interpreting § 2036(a).
Lessons from Strangi III
The important lessons that emerge for taxpayers utilizing an FLP in the wake of Strangi III include:
- Make sure the transferor retains sufficient assets and income to meet living expenses, including personal debts, funeral expenses and a reasonable amount for contingencies.
- The FLP should be an investment. There should be an apparent reason (other than tax avoidance) for family members to pool their assets in this way. The FLP should actively manage its assets.
- The transferor should receive adequate value for the assets transferred, such as a proportional interest in the FLP.
- If the transferor continues to make use of any transferred real estate, pay rent to the FLP that represents the value of that use.
- State explicitly in transfer documents that the transfer is absolute, unequivocal, irrevocable, and without possible reservation, and document the non-tax purpose of the transfer.
- Make sure the transferor does not retain the right to designate who will possess or enjoy the assets.
While Strangi III went badly for the taxpayer involved, it does not signal the end of the FLP as a useful device for transferring wealth. Strangi III was decided on its facts, although it does include additional clarification on what circumstances could bring assets of an FLP into the taxable estate under § 2036(a). For this reason, we advise clients to review their estate plans with their attorney in light of the Fifth Circuit's ruling.